The US economy has gone from drowning in liquidity to a liquidity crunch.
Angst over “vanishing” liquidity is now the chief concern among credit buyers in Europe, according to Bank of America’s client survey this month. Late-cycle worries, European political risk and sharp price moves this year — particularly in Italy — are feeding fears money managers will be unable to relinquish their positions in the next downturn.
“It’s not trade wars or an equity market correction that look to be keeping credit investors up at night,” Bank of America strategists, led by Barnaby Martin, wrote in a note this week. “The concern is a more pervasive rush for the exit at some point in the future.”
The concerns belie this summer’s rally. Premiums for euro-area investment grade bonds are back near their tightest level since late May, while the riskiest of U.S. debt has posted a 1.7 percent gain over the past three months.
An otherwise healthy economic backdrop has been overshadowed by extreme moves that are haunting cross-asset investors. From Italian government obligations to commodity markets and even tech shares, illiquidity fears are rising. It’s especially a concern in high-yield credit, where investors holding cash bonds can face steep penalties if they rush for the exit.
“These sorts of moves are the basis of my concern about how little real liquidity there is in both directions, and how fragile the current market structure can be,” Peter Tchir, the New York-based head of macro strategy at Academy Securities Inc., wrote in a note.
The Bank of America survey found that evaporating liquidity was the main worry for 22 percent of high-grade bond investors and 20 percent of investors in junk debt. In June, bubbles were the primary concern for 18 percent and 30 percent, respectively.
Thirst for Liquidity
To satisfy their liquidity thirst, investors are increasingly embracing a smorgasbord of products, from credit-default indexes and options to exchange-traded funds and even single-name CDS.
Illiquidity fears are grabbing investors across the Atlantic, too. The largest U.S. junk bond ETF, the iShares High Yield Corporate Bond fund, absorbed $1.5 billion in July, the biggest monthly inflow since 2015, according to data compiled by Bloomberg.
At the same time investors are taking out plenty of insurance, with the ratio of bearish to bullish options on the fund at the highest in 17 months.
Only 32 percent and 41 percent of U.S. high-grade and high-yield daily trading volumes takes place in the cash bond market, according to JPMorgan Chase & Co data. Amid an uptick in late-cycle market volatility, credit derivatives trading volume jumped 65 percent year-on-year in the first half of 2018, according to the U.S. bank.
“In the space of two months, the fear factor has swung from bubbles in credit (i.e. too much liquidity) to liquidity vanishing,” the Bank of America strategists wrote. “Why the sea-change? Interestingly, one clear pattern that is emerging from the strong summer rally is that of rising dispersion across all markets (especially high-yield).”
How about a little HYG volatility skew?
The spread between futures on equities and bond is at the largest gap since 2002.